Small Countries, Small Problems?

Both countries are blessed with natural resources, albeit with varying degrees. Do small countries suffer from their smallness? Do small countries enact better economic policies and grow faster? Are Bahrain and Qatar at a disadvantage because their size prevents them from diversifying into a wide range of activities, making them more vulnerable to terms of trade shocks than large countries such as Saudi Arabia?

It is usually claimed that smaller countries have more volatile output compared to their large counterparts. This is because generally smaller countries are economically less diversified than large countries. To see the merit of this argument, Charts 2 and 3 plot Bahrain and Qatar’s real output growth rate vis-à-vis Saudi Arabia’s real output growth rate. We can see that Saudi Arabia’s output growth is no less volatile than Bahrain’s output growth. In fact, the standard deviation, a common measure of variability, of Bahrain’s output growth during the 1980-2008 period is lower than that of Saudi Arabia’s output growth, 3 versus 4.83.

In comparison, Qatar’s output growth is far more volatile than Saudi Arabia’s output growth during the same period. The standard deviation of Qatar’s output is about 9.42, nearly double compared with Saudi Arabia’s standard deviation. Why is Bahrain’s output growth less volatile than Qatar and Saudi Arabia’s output growth? The reason for this seems clear. As a small country, Bahrain is far more diversified in endowments and production than Qatar and Saudi Arabia. For example, oil and gas account for less than 25% of Bahrain’s GDP, while the oil and gas sector provide about 50% of GDP in Saudi Arabia and nearly 60% of GDP in Qatar. Therefore, a shock in the oil price, has a major effect on Qatar and Saudi Arabia’s output; while shocks to different sectors in Bahrain (and to some extent in Saudi Arabia) tend to average out.

However, output volatility is not necessarily costly. As such, residents of a country care about their consumption smoothing, not output. People prefer to have a relatively steady amount of consumption from year to year rather than wild swings. For example, most households would prefer consuming $100,000 of goods a year for the next two years compared with consuming $50,000 this year and $150,000 next year. Households often borrow funds or reduce their savings when current resources are low in order to maintain their lifestyle.

To see how the GCC countries fare in smoothing their consumption patterns, in Charts 4 and 5 we plot the percentage change in real private consumption over the period 1980-2006. Several remarks are in order. First, compared to Saudi Arabia, consumption is far more volatile in Bahrain and Qatar. This result supports the general view that consumption growth is negatively correlated with population size. This result also suggests that households in Saudi Arabia manage their risks to consumption more efficiently than households in Bahrain and Qatar. One way households can lower some of the economic risk they face is by holding a portfolio of stocks and bonds. This allows households to smooth out fluctuations in the amount of goods and services they consume over time. However, the portfolio must be diversified.

Another way households can insure themselves against the economic risks they face is by borrowing and lending in the credit markets. Households may choose to save today to maintain a constant or higher consumption level in the future. Finally, a considerable portion of economic risks can also be mitigated with the help from the central government in the form of welfare benefits, subsidized transactions (such as water, electricity, and fuel), favorable tax system (zero income tax in the case of GCC countries), and promoting employments in public and private sectors (for example, Saudization, Qatarization). While the extent of central government’s support may be quite similar across the six GCC countries, or may somewhat differ between say Qatar and Saudi Arabia, the relatively less volatile consumption growth in Saudi Arabia compared with Bahrain and Qatar may indicate Saudi’s ability to smooth out shocks to income, and the corresponding consumption, via market mechanisms such as financial or credit markets. Perhaps the large savings accumulated by Saudi Arabia over the years helped its residents to smooth their consumption during economic downturns. Domestic savings and investment clearly stand out as possible factors behind Saudi Arabia’s ability to insure its residents against some of the economic risks they face.

Small countries tend to face other problems compared with large countries. For example, both Bahrain and Qatar may suffer from high-quality public officials given the limited pool of local candidates in these two countries. This reasoning has some merit given that public sectors in GCC countries are heavily dominated by their citizens, while foreign workers primarily dominate the private sectors. It is possible that both Saudi Arabia and UAE enjoy from a large pool of quality civil service compared with their neighboring Gulf states. A sensible solution to the problem of filling sufficiently important posts where there is limited local talent is to hire foreigners. Iceland, with about half of Bahrain’s population size, recently adopted this strategy by hiring a Norwegian expert to run the country’s central bank as an acting governor (see article). In the long-run, if managing public offices in smaller GCC states requires more expertise than can be acquired locally, they should hire experts from abroad.

Of course there are benefits of being small. For example, small countries tend to have less corruption than large countries as measured by Transparency International. In 2008, the Corruption Perception Index ranks Qatar as a less corrupt country (ranked 28) than Bahrain (ranked 43) and Saudi Arabia (ranked 80). Moreover, small countries tend to perform better in social indicators (health, education, life expectancy) than large countries. However, these elements appear to be quite asymmetric between Qatar and Bahrain. For example, health expenditure per capita is much higher in Qatar compared to Bahrain, reflecting Qatar’s very high per capita income.